Capital Gains Tax Cuts: Myths and Facts

Capital gains play a unique role in
fostering economic activity, especially by entrepreneurs in
high-technology areas.

The current top statutory rate of 20
percent significantly exceeds the optimal tax rate - the rate best
for the economy -- because the tax code's bias towards consumption
over investment and multiple taxation of investment returns limit
investment and retard economic growth.

In fact, many economists, including
Federal Reserve Chairman Alan Greenspan, believe that the optimal
tax rate on capital gains is 0 percent.

Because government first takes money
through corporate income taxes, taxation of capital gains (and
dividends) represent double-taxation of investment returns and
should be eliminated.

Myth 2: If there is a capital gains tax cut, it should be
temporary and it should not be available to all investors.

Fact 2: Only a permanent capital gains cut available to all
investors - include those who invested long ago -- will stimulate
new investment and revive economic growth.

A temporary cut will induce people to
sell assets, but it will not stimulate new investors who will face
today's high rates again in the future after the temporary
reduction has expired.

A temporary cut will "lock-out" new
investment and will hurt economic growth.

The induced selling without
incentives for new investment will further depress stock and other
asset prices and will not stimulate new investment. By unlocking
held assets and inducing people to sell investments, a temporary
cut may increase tax revenue - it may not, though, because asset
prices will be lower - but it will not help stimulate economic
growth.

A permanent cut will provide the
incentives for people now to sell long-held unproductive assets and
for people now and in the future to make new productive
investments.

Fact 3: Cutting capital gains tax rates will, as it has in
the past, cause asset values, including stock markets, to rise.

Some people claim that lowering
capital gains tax rates will cause the stock market to fall,
because people would sell their investments. By this silly logic,
if people want to increase stock market values, then there should
be an increase in capital gains tax rates, because, then investors
would be less willing to sell investments.

In fact, lowering capital gains tax
rates increases the prices of stocks and other assets. Stock
markets reflect the collective actions of people looking
forward.

Lowering the cost of capital by
decreasing tax rates on investment returns will increase asset
values.

For example, the 1997 cut in the top
capital gains tax rate from 28 percent to 20 percent increased
stock prices by approximately 8 percent.

Capital gains taxes
disproportionately hurt the elderly, low and middle-income
investors who have less discretion over the timing of their capital
gains.

Most people who report capital gains
do not have high annual incomes.

People with high incomes are most
sensitive to capital gains tax rates, because they possess the most
flexibility and means to avoid high tax rates. When capital gains
tax rates are high, people with high incomes do not sell their
assets and realize their gains.

High-income people pay a greater
percentage of capital gains taxes when capital gains tax rates are
low than when capital gains tax rates are high.

High capital gains tax rates make
capital scarce. When capital is scarce it goes to safe investments.
Low capital gains tax rates make capital abundant. When capital is
plentiful it goes to "riskier" investments - such as inner cities
and disadvantaged areas.

Myth 5: Lowering capital gains tax rates will not lead to
more investment.

Too often politicians incorrectly
concern themselves with the effects of policy changes on the
federal budget rather than on the national economy. As James
Carville said in 1992, "It's the economy, Stupid." (Note: He didn't
say, "It's the budget, Stupid.")

The correct goal of tax policy should
be to maximize economic growth, not federal tax revenue.
Consequently, the optimal tax rate is the rate that is best for the
economy, and this rate is lower than the rate that provides the
government with the most tax revenue.

The government should not act like a
business trying to maximize revenue. Rather, the goal of tax policy
should be to enhance economic growth and raise only as much tax
revenue as is needed, not as much as is possible.

More investment and greater
realizations caused by lower capital gains tax rates lead to
increased capital gains tax revenue and more federal revenue from
other taxes such as corporate taxes, personal income taxes, and
payroll taxes.

When predicting the budgetary effects
of capital gains tax rate changes, it is necessary to account for
behavioral responses by using "dynamic" rather than "static"
scoring.

For example when a corporation earns
$100 profit, the government takes $35 in corporate taxes, leaving
$65 distributed to investors taxed at 20%. The government takes
another $13 (20% of $65) in capital gains taxes, leaving investors
with $52 and government with $48 out of the original $100 profit.
Thus, an effective tax rate on capital gains of 48%. (Note: Since
dividend are also subject to double taxation, but are taxed at
ordinary income tax rates, the effective tax rates on dividends can
approach 60%!)

The most counterproductive and unfair
characteristic of the tax on capital gains is that it taxes
inflation, because capital gains are not adjusted for inflation.
The example above does not even include the fact that capital gains
taxes include taxes on inflation, and, therefore, actually tax
investors at even higher real tax rates - at times more than
100%!

For example, if an investment of
$1000 rises in value to $1100, while prices generally have risen
10%, there is no real (after inflation) increase in value. However,
an investor who sold this asset for $1100 would still have to pay
taxes on the inflationary gain of $100. At the current top
statutory rate of 20%, this investor would pay $20 in capital gains
taxes on an investment that produced no real gain. The result, in
this case, is a tax rate of infinity!

These high effective tax rates force
investors to retain assets, increasing the "lock-in" effect.
Moreover, the policy hurts economic growth by inhibiting new
investments, because under current law inflation is a risk
investors must bear.

The tax on inflation most severely
punishes the elderly, low-income, middle-income, and less
successful investors, because these people are less able to adjust
the timing of their investment decisions than investors with higher
incomes.

Indexing (adjusting) capital gains
for inflation - as other countries have done - would eliminate the
unfair and harmful tax on inflation.

Rep. Peter Roskam (R-IL) says it's "a great way to start the day for any conservative who wants to get America back on track."

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